The country needs to rebalance its economy before opening up capital flows

by: Martin Wolf.

If something cannot go on forever, it will stop.” This is “Stein’s law”, after its inventor Herbert Stein, chairman of the Council of Economic Advisers under Richard Nixon. Rüdiger Dornbusch, a US-based German economist, added: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”These quotations help us think about the macroeconomics of China’s economy. Growth at rates targeted by the government requires a rapid rise in the ratio of debt to gross domestic product. This cannot continue forever. So it will stop. Yet, since the Chinese government controls the financial system, it can continue for a long time. But the longer the ending is postponed, the greater the likelihood of a crisis, a big slowdown in growth, or both.I have argued that it is in the interests of China and the rest of the world to keep their financial systems separate. The rapid growth of indebtedness and the size of its financial system represent a threat to global stability. China needs to rebalance its economy and stabilise its financial system before opening up capital flows. Western financiers will have a different view. We should ignore this sectional interest.Yet this raises a big question: will China achieve the needed rebalancing? As was true in the west before the financial crises of 2007-08 and the eurozone crisis that followed, the maintenance of stable growth in China has coincided with an explosive growth in indebtedness. As a paper from the International Monetary Fund stresses: “Credit growth has been averaging around 20 per cent per year between 2009 and 2015, much higher than nominal GDP growth and the previous trend.” The picture is disturbingly similar to that of pre-crisis Japan, Thailand and Spain.The turning point in these credit trends was 2008. That was no accident. Between 2000 and 2007, gross savings soared from 37 per cent to nearly 50 per cent of GDP. About half of this extraordinary rise financed additional domestic investment and half financed a rise in the trade surplus. Then came the western crisis. China decided (rightly) that its huge trade surplus was no longer sustainable. It raised investment, instead. That had already risen from 34 per cent of GDP in 2000 to 41 per cent in 2007. It then jumped to 48 per cent in 2010. To achieve this outcome, the Chinese authorities promoted explosive credit growth. Before 2008, China had largely exported the credit surge attendant upon its massive rise in savings. After the crisis, it re-imported it. A recent analysis by Credit Suisse concludes that credit needs to grow about twice as fast as nominal GDP if the government is to hit its target of real growth of 6.5 per cent. The IMF adds that the credit growth coincides with declining returns on corporate assets, deteriorating corporate creditworthiness, falling efficiency of investment and rising financial complexity. We have seen this elsewhere. So will China be any different? The answer is yes and no. Yes because, like Japan, China is a high-saving, creditor country. The government controls the financial system and operates exchange controls. It may well avoid a crisis. Yet the answer is also no, because the authorities will need ever more credit expansion to achieve ever less growth. Chinese growth might then expire with a whimper, not a bang.What are the possible escapes from the trap? One option would be for the authorities just to halt credit growth. If China’s growth depended on consumption alone, one might expect it to fall to 3-4 per cent a year. But China’s investment rate is still close to 45 per cent of GDP. Such a high rate of investment could not be justified if growth were so slow. Investment would then fall, creating a recession. The only escape would be for the government to take over the investment process, rendering market-oriented economic reform a nullity.A second option would be to halt credit growth and let savings flow abroad, via a huge expansion in the current account surplus. Yet the trade discussions between Donald Trump and Xi Jinping in Florida show this would not be acceptable. Countries willing and able to run offsetting external deficits do not exist.A third option would be to halt credit growth and raise consumption sharply, to offset a decline in investment. The problem here is that household disposable income is only a little above 60 per cent of GDP, while private consumption is about 40 per cent of GDP. Such savings rates are not so high by Asian standards. More than half of national savings consist of profits and government savings. If one wanted consumption to grow faster than now, the share of household incomes in GDP or of household wealth in total wealth needs to soar. The former would squeeze profits and investment. The latter would mean transferring public assets to households. Neither looks technically and politically workable. So consumption will not keep the economy from stalling.A final (and perhaps best) option would be for the government to put much of the debt on its own balance sheet. It could restructure existing debt and be the principal borrower in future. China would become a premature Japan. While government debt would rise, the borrower would be the country’s most solvent entity. Meanwhile, the private economy would be allowed to adjust to market signals.Today, China can achieve growth of over 6 per cent only with rapid rises in indebtedness. All escapes from this trap are hard. The economy is now slowly rebalancing into consumption. But this will take well over a decade. Will the growth of debt be sustained until then? I doubt it.

CAMBRIDGE – It appears that a new consensus has taken hold these days among the world’s business and policy elites about how to address the anti-globalization backlash that populists such as Donald Trump have so ably exploited. Gone are the confident assertions that globalization benefits everyone: we must, the elites now concede, accept that globalization produces both winners and losers. But the correct response is not to halt or reverse globalization; it is to ensure that the losers are compensated.

The new consensus is stated succinctly by Nouriel Roubini: the backlash against globalization “can be contained and managed through policies that compensate workers for its collateral damage and costs,” he argues. “Only by enacting such policies will globalization’s losers begin to think that they may eventually join the ranks of its winners.”

This argument seems to make eminent sense, both economically and politically. Economists have long known that trade liberalization causes income redistribution and absolute losses for some groups, even as it enlarges a country’s overall economic pie. Therefore, trade deals unambiguously enhance national wellbeing only to the extent that winners compensate losers. Compensation also ensures support for trade openness from broader constituencies and should be good politics.

Prior to the welfare state, the tension between openness and redistribution was resolved either by large-scale emigration of workers or by re-imposing trade protection, especially in agriculture. With the rise of the welfare state, the constraint became less binding, allowing for more trade liberalization. Today the advanced countries that are the most exposed to the international economy are also those where safety nets and social insurance programs – welfare states – are the most extensive. Research in Europe has shown that losers from globalization within countries tend to favor more active social programs and labor-market interventions.

If opposition to trade has not become politically salient in Europe today, it is partly because such social protections remain strong there, despite having weakened in recent years. It is not an exaggeration to say that the welfare state and the open economy have been flip sides of the same coin during much of the twentieth century.

Compared to most European countries, the United States was a latecomer to globalization. Until recently, its large domestic market and relative geographical insulation provided considerable protection from imports, especially from low-wage countries. It also traditionally had a weak welfare state.

When the US began opening itself up to imports from Mexico, China, and other developing countries in the 1980s, one might have expected it to go the European route. Instead, under the sway of Reaganite and market-fundamentalist ideas, the US went in an opposite direction. As Larry Mishel, president of the Economic Policy Institute, puts it, “ignoring the losers was deliberate.” In 1981, the “trade adjustment assistance (TAA) program was one of the first things Reagan attacked, cutting its weekly compensation payments.”

The damage continued under subsequent, Democratic administrations. In Mishel’s words, “if free-traders had actually cared about the working class, they could have supported a full range of policies to support robust wage growth: full employment, collective bargaining, high labor standards, a robust minimum wage, and so on.” And all of this could have been done “before administering ‘shocks’ by expanding trade with low-wage countries.”

Could the US now reverse course, and follow the newly emergent conventional wisdom? Back in 2007, political scientist Ken Scheve and economist Matt Slaughter called for “a New Deal for globalization” in the US, one that would link “engagement with the world economy to a substantial redistribution of income.” In the US, they argued, this would mean adopting a much more progressive federal tax system.

Slaughter had served in a Republican administration, under President George W. Bush. It is an indication of how polarized the US political climate has become that it is impossible to imagine similar proposals coming out of Republican circles these days. The effort by Trump and his Congressional allies to emasculate former President Barack Obama’s signature health-insurance program reflected Republicans’ commitment to scaling back, not expanding, social protections.

Today’s consensus concerning the need to compensate globalization’s losers presumes that the winners are motivated by enlightened self-interest – that they believe buy-in from the losers is essential to maintain economic openness. Trump’s presidency has revealed an alternative perspective: globalization, at least as currently construed, tilts the balance of political power toward those with the skills and assets to benefit from openness, undermining whatever organized influence the losers might have had in the first place. Inchoate discontent about globalization, Trump has shown, can easily be channeled to serve an altogether different agenda, more in line with elites’ interests.

The politics of compensation is always subject to a problem that economists call “time inconsistency.” Before a new policy – say, a trade agreement – is adopted, beneficiaries have an incentive to promise compensation. Once the policy is in place, they have little interest in following through, either because reversal is costly all around or because the underlying balance of power shifts toward them.

The time for compensation has come and gone. Even if compensation was a viable approach two decades ago, it no longer serves as a practical response to globalization’s adverse effects. To bring the losers along, we will need to consider changing the rules of globalization itself.

By Marc FaberExcerpted from the Gloom, Boom & Doom Report for April 2017

“For as wealth is power, so all power will infallibly draw wealth to itself by some means or other.”
– Edmund Burke (1780)

“Of great riches there is no real use, except it be in the distribution.”
– Francis Bacon (De Dignitate et Augmentis Scientiarum, 1623)

“That mankind as a whole shall become richer does not, of necessity involve an increase in human welfare.”
– John Bates Clark

“Riches: The saving of many in the hands of one.”
– Eugene V. Debs

Those persons who comprise the independent classes are dependent upon two things: the industry of their fellow creatures; and injustice, which enables them to command it.
– Based on John Gray (A Lecture on Human Happiness, 1825)

“No rich man is ugly.”
– Zsa Zsa Gabor

Introduction

The other day, I was interviewed by CNBC. One of the participants on their panel asked me whether I believed I was providing a service to investors by warning them that stocks could decline by between 20% and 40%, or even more. He further questioned my morality in dissuading investors from buying stocks that were being touted as a once-in-a-lifetime opportunity to make money following their March 2009 lows. Aside from the inaccuracy of the interviewer’s statement that I had been keeping investors out of the market, I was taken aback by the notion of a CNBC employee talking about morality. Every year, I attend several conferences and Hillary Clinton about ethical behaviour, Trump about modesty and unpretentiousness, Bernanke and Yellen about “honest money”, and mobster Whitey Bulger about mercy. (Federal prosecutors indicted Bulger for 19 murders.) Still, the question prompted me subsequently to contemplate whether periods of hig h monetary inflation (printing money) make people wealthier in real terms. Last month, I explained that it is an irrefutable fact that inflation-adjusted millennials earn less, and have less wealth, than the baby boomers hadâ¨at the same age. (See Table 1 for easy reference.)

Also, it is true that US household wealth is at an all-time high – certainly in nominal terms (see Figure 1). (As an aside, Ed Yardeni publishes very useful figures about US and global “Flow of Funds”.)

But, as I have explained in the past, the distribution of wealth has become more unequal, with the 0.1% (the super-wealthy) doing extremely well, while the median household’s or asset owner’s wealth has declined by close to 40% in real terms (adjusted by the CPI) from its peak in 2007 (see Figure 2). I now wish to make some further observations about the increase in household wealth, in both nominal and real terms, of the 0.1%.

The Wealth Illusion

Say I own a nice property in Beverly Hills, Newport Beach or Palm Beach. I bought the property 15 years ago for US$1 million. It’s now worth US$10 million. Over the same period, the CPI is up by 25%. Therefore, adjusted for inflation, my house has appreciated by 75%, correct? Not so fast. First of all, the cost-of-living increase over that period of time has been far greater than the CPI indicates (and includes taxes, home maintenance costs, school fees for my children, salaries of my housekeepers – that is, unless I’m a member of Congress who employs illegals).

So, the real wealth increase, even measured by an index of consumption-related expenditures, may be far lower than that which is deflated by the official CPI.Furthermore, let us assume that I decide to sell my US$10 million house in Beverly Hills with the intention of buying another house in Palm Beach, Newport Beach, San Francisco, or an equivalent location. What will I pay for that house? I suppose it will be something like the inflated price at which I’m selling my existing home. I invite a statistician to explain to me what is a more appropriate index against which to measure the price of my house: the CPI, or an index of property values in an equivalent location?

Measured against the CPI, my house has appreciated; however, measured against a property price index it may have gone up somewhat more, or somewhat less, than the index, depending on how the prices of other homes comparable to my house have moved in the same location. Now, someone might argue that, regardless, I would have done very well compared to the median US household and the 50% of Americans who have no assets at all. That argument is correct. In an asset inflationary environment, asset holders do far better than people who don’t own any assets. (The same is true in a consumer price inflationary environment such as we had in the 1970s.) But my point is that, unless, after selling my US$10 million house, I move to an area that has appreciated only very little or has even gone down in price, in reality I have no net wealth gain. I concede that I could move to Mexico City, Rio de Janeiro, Bahia, New Orleans, Bali, Pattaya, Maputo, or a similar location, and purchase a house equivalent to the Beverly Hills house that I’ve just sold, but for a fraction of the price. In some places, I might even improve my standard of living meaningfully. But in other locations, the environment may not be to my liking at all. The point I wish to make is that my wealth increase as represented by the Beverly Hills house is largely illusionary, unless I sell that expensive property and move to a far less expensive area. The same would be true of an investment in the stock market. In the 1970s, I could buy the Dow Jones Industrial Average for less than 1,000. Now, I need to pay 21,000 for one Dow Jones, which is 21-times what I would have paid in the seventies (see Figure 3). Over the same period of time, US household wealth has increased by about the same amount (see Figure 1).

Naturally, the total return of the stock market (including reinvestment of dividends) over the same period was far higher. The Dow Jones US Total Stock Market Index appreciated more than 100-fold between 1970 and 2017 (see Figure 4). (The Dow Jones US Total Stock Market Index is an all-inclusive measure composed of all US equity securities with readily available prices.) The total returns of other indices such as the S&P 500 and the Dow Jones Industrial Average are of a similar magnitude, whereby value outperformed growth over the entire period.

There are several reasons why household wealth increased far less than the total return of the stock market. The main component of household wealth is pension fund assets (approximately US$22 trillion). Since pension funds hold a diversified portfolio of assets consisting of stocks, bonds, cash, real estate, alternative investments, etc., they underperformed the total return of a stock portfolio. Households also have large real estate holdings in the form of owner-occupied homes. Owner-occupied homes are a cash-flow negative asset (taxes, maintenance costs, mortgage payments, etc.). The value of these (cash-flow negative) homes has appreciated since 1970; however, they have appreciated (with few exceptions) far less than have stocks whose dividends were reinvested. The same goes for households’ holdings of bonds and cash, and their own businesses. The value of households’ direct ownership of equities increased at about the same rate as household wealth, but at a far lower rate than the total return of equities because households tended to be net sellers of equities. I assume that households felt increasingly comfortable holding the bulk of their wealth in pension fund assets and, therefore, reduced their direct ownership of equities.

Still, there is no question that US household wealth has increased significantly since the 1970s (see Figure 1). But, can we say that the record US$89 trillion wealth of the household sector is an indication of how well the economy is performing? Furthermore, can we conclude that when a part of this household wealth is liquidated, a huge consumption and economic boom will follow? The answer to the first question is simple. Most of the increase in household wealth accrued to a tiny percentage of the population (see Figure 2). In fact, following the Trump rally, the top 0.1% of households own more than the bottom 90%. Also, as I explained above, the increase in value of my Beverly Hills house is of limited utility if I wish to continue living in an equivalent house in an equivalent area somewhere else. We then need to consider the increase in the US population, which in 1970 was 205 million and is now 318 million.

Therefore, a better indication of American wealth than total household wealth would be per-capita wealth. Lastly, as I explained above, the largest component of US household wealth is pension fund reserves, currently valued at US$22 trillion. But there are some question marks over these assets and whether they are really worth this amount. Last October, my friend Fred Sheehan (frederick.sheehan@verizon. net) explained just how underfunded pension funds were, citing (among other examples) the Commonwealth of Massachusetts Funded Ratios (see Table 2).

In this respect, it’s interesting to note that The New York Daily News recently carried an article about the Teamster Local 707’s pension fund (see February 26, 2017), which has encountered serious financial problems. According to the Daily News, one trucker reported: “It’s a nightmare, it has just devastated all of our lives. I’ve gone from having $48,000 a year to less than half that.” Again according to the Daily News, another Teamster pensioner, Narvaez, explained that:

...like 4,000 other retired Teamster truckers, [he] got a letter from Local 707 in February of last year. It said monthly pensions had to be slashed by more than a third. It was an emergency move to try to keep the dying fund solvent. That dropped Narvaez from nearly $3,500 to about $2,000.

The stopgap measure didn’t work – and after years of dangling over the precipice, Local 707’s pension fund fell off the financial cliff this month. With no money left, it turned to Pension Benefit Guaranty Corp., a government insurance company that covers pensions.

Pension Benefit Guaranty Corp. picked up Local 707’s retiree payouts – but the maximum benefit it gives a year is roughly $12,000, for workers who racked up at least 30 years. For those with less time on the job, the payouts are smaller.

Narvaez now gets $1,170 a month – before taxes. Ex-trucker Edward Hernandez, 67, went from $2,422 a month to $1,465 last year. As of this month, his gross check is $902. After federal taxes, it’s $721 – but he still has to pay state and city taxes.

“We have guys on Long Island who are losing their houses, the taxes are so high out there,” Hernandez said. Milton Acosta, 75, was a dockworker in Local 707. He retired at age 62, figuring his union pension of $2,300, coupled with his Social Security, would keep him and his wife afloat. Now his pension is $760 a month after taxes, he said.

As heartbreaking as their stories are, they are not new to Thomas Nyhan, executive director and general counsel of the Central States Pension Fund.

The same crisis now hitting Local 707 has been stewing among numerous Teamster locals around the country for the past decade, he said, and that includes in upstate New York. The trucking industryâ¨– almost uniformly organized by Teamsters – has suffered enormous financial losses in its pension and welfare funds due to a crippling combination of deregulation and stock market crashes, Nyhan said.

“This is a quiet crisis, but it’s very real. There are currently 200 other plans on track for insolvency – that’s going to affect anywhere from 1.5 to 2 million people,” said Nyhan. “The prognosis is bleak minus some new legislative help.” And it’s not just private-sector industries that are suffering, he added.

“Municipal and state plans are the next to go down – that’s a pension tsunami that’s coming,” he said. “In many states, those defined benefit plans are seriously underfunded – and at the endâ¨of the day, math trumps the statutes.” [Emphasis added in each instance.]

(As an aside, Illinois is facing the worst pension crisis of any US state, with unfunded obligations totalling US$130 billion, according to the state’s Commission on Government Forecasting and Accountability. That amounts to about US$10,000 in debt for each resident.)

I urge my readers to peruse once again Fred Sheehan’s report, entitled “Public Pension Recipients: Start Saving. You Are on Your Own”, in the October 2016 GBD report. I explained at the time that the shocking funding level and its deterioration (see Table 2), about which Sheehan writes, is also evident in the corporate sector and in Europe. So, whereas prior to the 2008/2009 crisis S&P 1500 companies were fully funded, today funding has dropped below 80% (see Figure 7 of the October 2016 GBD report). I also noted that I found the deteriorating funding levels of pension funds remarkable because, post-March 2009 (S&P 500 at 666), stocks around the world rebounded strongly and many markets (including the US stock market) made new highs. Furthermore, government bonds were rallying strongly after 2006 as interest rates continued to decline. My point was that if, despite truly mouth-watering returns of financial assets over the last ten years, unfunded liabilities have increased, what will happen once these returns diminish or disappear completely? After all, it’s almost certain that the returns of pension funds (as well as of other financial institutions) will diminish given the current level of interest rates and the lofty US stock market valuations (see Figures 12 and 13 in the March 2017 GBD report).

The Road to Perdition

The next time an economist tells you that the US economy is rock solid because household wealth keeps going up and is now almost US$93 trillion (following the Trump rally), keep in mind that this wealth is unevenly distributed (see Figure 2) and that the US$22 trillion in the form of pension funds is completely inadequate to meet those funds’ obligations to pensioners. Either contributions will have to increase massively, or benefits will have to be cut, as we have seen in the case of the Teamster Local 707’s pension fund. I should also like my readers to reflect on the hardships that have to be endured by retirees if their benefits are cut by more than 50%, as we have seen in the examples quoted above by the Daily News. Furthermore, if, as Thomas Nyhan states, there is a quiet but very real crisis “that’s going to affect anywhere from 1.5 to 2 million people” (probably far more than that number nationwide), consider what the impact on consumption and the US economy will be.

There is another point I need to explain. Let us assume that I belong to the 0.1% and that I have assets of US$100 million. Because of the Trump rally, I make a profit of US$5 million within a month. Will it change my consumption? Maybe at the margin (the trickle-down effect), but very little overall, compared to a thousand lower middle-class people suddenly making an additional US$1,000 each. In that case, it’s likely that the 1,000 people who enjoy a sudden “monetary” windfall of US$1,000 will spend most of it.

Therefore, if wealth is concentrated in the hands of very few people, as it is now, the economic impact of household wealth rising is minimal. In other words, the level of household wealth is a very poor indicator of how the economy is really performing. This is especially true in a money-printing environment.

In this context, I need to clarify another matter. Most economistsâ¨have argued that inflation is low and growth is anaemic because the velocity of money has been declining sinceâ¨the late 1990s (see Figure 5). These economists will argue that when the velocity of money picks up, inflation and growth will accelerate. But how can velocity accelerate?

Let us go back to Figure 2. The top 0.1% of asset holders (the super-rich) will unlikely spend their wealth if they liquidate some assets. Let’s say that Warren Buffett makes another US$1 billion because of the Trump rally. Will he spend that money? It’s unlikely.

He might reduce his equity exposure and build up his cash holdings or buy some other assets, but his billion- dollar capital gain isn’t going to cause him to go out and buy another 50 tailor-made suits, neckties and sets of silk pajamas. In other words, the Fed and other central banks can further increase their balance sheets, whi ch will boost asset prices still higher. However, it will only worsen the wealth inequality because only the existing asset holders will benefit, and it will further deflate the velocity of money (see Figure 5). (In fact, just how little impact the rising US stock market has had on the economy is evident from the TDn2K’s Restaurant Industry Snapshot, which announced that restaurant “same-store sales fell –3.7 percent in February, with traffic declining –5.0 percent.... Fine dining and upscale casual were the strongest segments in February. Fine dining was the only segment up overall.” But please note that “fine dining” only accounts for 5% of restaurant sales. The report added: “Consumers are spending, but they are being battered by rising inflation.”)

There are, however, three ways in which the velocity of money could be increased. A complete collapse of asset markets would bring about deflation and improve the affordability of goods, services and assets for the median household – certainly relative to the 0.1%. In this scenario, the velocity of money will increase, but I very much doubt that the increase in velocity would bring about stronger growth and higher inflation.

A massive dose of helicopter money dropped on the 50% of Americans who are struggling and have no assets would probably be the most potent tool for boosting the velocity of money, inflation and economic growth – that is, temporarily. I say “probably” and “temporarily” because it is far from certain that this intervention would improve “real” economic activity and “real” growth. Also, “Helicopter Money One” would have to be followed by “Helicopter Money Two”, and so on, which would have numerous very negative consequences (a collapse in the dollar, very high consumer price inflation rates, further increase in wealth inequality, etc.). The third option for boosting the velocity of money would be to expropriate a significant share of the wealth of the top 0.1% of wealth owners and distribute it to the 50% who are the lowest-income recipients. Again, this would boost consum ption only temporarily and it would be a complete disaster for the overall economy. Disturbingly, this is what will be the ultimate outcome unless an authoritarian dictator seizes power, in which case the outcome could be even worse.

Let me explain. Should the economy weaken and enter another recession (which is inevitable, sooner or later), QE4 will be a given. The result of QE4 would be more of the same: rising wealth inequality as asset prices continue to increase (this time, very selectively) whereby the median household is left further behind. Therefore, the next step by the interventionists will be – possibly simultaneously with QE4 – helicopter money.

However, make no mistake.

Helicopter money whose objective would be to kick-start the economy would be almost instantly captured by the powerful corporate sector and the asset owners, because the increased consumption would increase consumer prices and boost corporate profits. In other words, unless the interventionists with their fiscal and monetary policies engineer an asset price collapse (about the last thing they will do intentionally), the top 0.1% will continue to gain at the expense of just a bout everybody else. Don’t misunderstand me. I am not blaming the 0.1% for snatching an increased share of the income and wealth pie.

They were in a better position and more able to take advantage of globalisation and monetary inflation than the vast majority of Americans. Moreover, their wealth allowed them to manipulate governments, their agencies, the lawmakers and regulators, etc. (especially central banks and treasury departments) for implementing policies that would greatly benefit them. Thus, their share of the wealth and income pie exploded (see Figures 2 and 6).

I admit that the statistics compiled by Thomas Piketty and Emmanuel Saez should be taken with a grain of salt, but the expansion of CEOs’ salaries relative to the salaries of workers does support the fact that the 0.1% have done very well compared to workers (see Figure 7).

According to the Bureau of Economic Analysis, CEOs of the largest US companies now earn more than 300 times what workers earn, compared to CEO salaries of less than 30 times what workers earned in the 1970s. (The Bureau of Economic Analysis computes CEO annual compensation by using the “option realised” compensation series, which includes salary, bonus, restricted stock grants, options exercised, and long-term incentive payouts for CEOs at the top 350 US firms ranked by sales.)

Above, I mentioned that wealthy people, including the CEOs of major companies, were in a better position and more skilful at taking advantage of globalisation and monetary inflation than the vast majority of Americans. Monetary inflation, the secular decline of interest rates after 1981, the process of outsourcing, clever lobbying, etc. all contributed to rising corporate profits, which in turn allowed executives to boost their compensation without any objection from shareholders. In fact, we can see that CEOs’ compensation increases mirror the increase in the S&P 500 (see Figure 8). I want to stress that I have no idea whether CEOs should earn 30 times more than workers or 500 times more. (I also earn more than 500 times the salaries of my housekeepers in Chiang Mai, which difference can be partly explained by them earning a Thai local salary whereas I have an international income.) The fact is that, in a market economy, the market will determine the “price” of CEOs and of labour. But, as I said above, I suppose that wealthy people and corporate leaders (especially in the financial sector) were in a position to manipulate the system, which enabled them to heist a disproportionally large share of the economic pie. When money printing began to accelerate in and after the late 1990s, the financial sector managed to raid almost all the central banks’ newly printed money and some more ... with impunity. (According to the organisation Americans for Financial Reform, “in the 2015–16 election cycle, Wall Street banks and financial interests reported spending over $2.0 billion to influence decision- making in Washington. That total — of officially reported expenditures on campaign contributions and lobbying — comes to more than $2.7 million a day. It also works out to over $3.7 million per member of Congress.”

We have a system in place that is based on fiscal and monetary policies, and laws and regulations, that favour the corporate elite, the largest corporations, the captains of finance, and the 0.1% in general, because they are the asset holders. This moneyed class will not give up its privileges voluntarily. The privileged class will do everything in their power to keep these favourable conditions in place, which would include money printing in one or another form if there is a recession or if asset markets decline meaningfully (say, to the February 2016 low of 1,810 for the S&P 500). As I said, I’m not discussing these issues because I have some rancour about these “conditions” from which I actually profiteered greatly. I am discussing them because I believe that an unstable system in which the majority of people lose out to the privileged few is simply not sustainable and will end either with a Bernie Sanders-type socialist gaining power or with the establishment of a dictatorship. Democracies promised a level playing field in society, but that certainly does not seem to be in place nowadays. I suspect that we have never yet had a level playing field, but I feel that we are reaching a tipping point where something is likely to give, and I am afraid that this “something” could be the inflated asset markets.

- A suitable store of value.- A potential hedge against the frailties of the global monetary system.- A potentially undervalued asset?

Why do we own gold?

In this short memo (written on March 10th, 2017), we would like to present our reasoning for including gold to our overall asset allocation.

1.A suitable store of value

In a piece of research entitled Of The Evolution Of The Global Monetary System that we wrote in June 2016, we recounted that for the vast majority of human economic history spanning thousands of years, gold and silver coins were the most commonly used form of money (please reach out to us if you'd like to read this memo). They fulfilled all of the generally accepted conditions for something to be suitable as 'money,' namely i.) a store of value, ii.) a unit of account, and iii.) a medium of exchange.

Perhaps the most important of these conditions is the first one: a store of value. This means that whatever we choose to use as money - be it silver, gold, or simply paper currency accepted as a legal tender of debts and backed by the faith and credit of a sovereign government - it must preserve its purchasing power over time. The phenomenon that hinders this from occurring is inflation, or the gradual depreciation of currency relative to the value of what it can purchase in the real economy. From the perspective of individual economic actors, this phenomenon is more easily observable as a persistent increase in the price of goods and services.

Ensuring price stability is one of the foundations of a sound and stable capitalistic system. It protects savings from confiscation through inflation; and thus fosters capital formation, which is a key driver of economic development. While most economic textbooks typically associate inflation with brisk demand or surging input costs, by far the most significant cause of inflation is expanding the money supply at a faster rate than what is consistent with the size and growth potential of an economy. It can also be argued that such unwise monetary policies play a major part in creating long-term business cycles via credit booms and subsequent busts, which often lead to recession or even depressions.

Our long-term track record of managing price stability under various monetary systems paints an unequivocal picture. As shown in Figure 1 below, inflation in the US averaged about 0% to 1% per annum between 1792 and the early 1930s, a 140-year period that coincides with silver- and gold-based monetary systems, bar for a brief period during the American Civil War.

By contrast, from the early 1930s onwards, as the US started to expand its money supply at a much faster rate than previously, the average inflation rate picked up to about 3% p.a. Then, following the closing of the 'gold window' in 1971, at which point US dollars were no longer redeemable in gold at all, monetary expansion accelerated further and inflation picked up closer to the 4% p.a. mark. Just to put this into mathematical context: the power of compounding works both ways, and it only takes 18 years for a currency depreciating at 4% p.a. to lose half of its value!

Figure 2 below essentially depicts the exact same information, but presented as the purchasing power of gold and the US$ for a given basket of commodities between 1791 and 2013. It shows a clear inflection point when the US first devalued, and then eventually completely broke off the relationship between the dollar and gold, as well as the impact this had on their respective ability to act as an adequate store of value. While gold has basically maintained a steady purchasing power, the dollar has lost over 98% of its original purchasing power over that 220+ year period.

So, to sum up: on the one hand, we have precious metals like gold that have a track record spanning centuries of acting as an adequate store of value; and on the other hand, we have every single man-made currency without exception that has lost nearly all of its purchasing power over the long term (as shown in Figure 3 below). If you'd have to explain this to a 5-year old child, you'd probably say something along the lines of: 'when you create a large amount of money out of thin air, you can't expect it to keep its value over time. Gold can't be created out of thin air.'

Prudent financial planning recommends that a portion of our wealth should be held in reserve, as a safety net to protect us against hard times and unexpected events. Given its vastly superior ability to store value over time relative to paper currency, it appears obvious to us a portion of our long-term reserves should be held in physical gold.

2.A potential hedge against the frailties of the global monetary system

We've previously described the manner in which gold is a very effective hedge against inflation relative to paper currencies. But beyond that, does it also offer a potential source of downside protection against various asset classes? As shown in Figure 4 below, gold is essentially uncorrelated to stock returns, but does offer a small downside protection when stock prices drop significantly. Similarly, gold is largely uncorrelated to bond prices, although a small positive relationship can sometimes be observed during times of financial distress, as both are considered as a 'safe haven' asset. So, generally speaking, gold offers a source of uncorrelated returns, which at the very least can be beneficial as a 'portfolio diversifier' that reduces volatility in an overall asset allocation.

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The main potential hedge that we believe gold offers is against the frailties of the global monetary system. As described at length in our Annual Report 2016, the extremely expansionary monetary policies of central banks over the past decades, and particularly since the financial crisis of 2008, have facilitated a rapid accumulation of debt to a clearly unsustainable level.

As long as creditors are confident in governments' ability to honour their long-term financial obligations, and not devalue their currencies or pursue monetary policies that may lead to a high level of inflation in doing so, then the current global monetary system may perpetuate itself for many decades still. But let's be absolutely honest with ourselves: it is the very definition of a 'confidence game.'

Let's put this into the appropriate context in order to illustrate how fragile this confidence really is. We've previously described how currency used to be 100% backed by gold[1]. Figure 5 below illustrates the physical gold coverage of the US monetary base between 1918 and 2016.

Note that this ratio is not only impacted by the amount of gold reserves held, but also largely by the price of gold, so it can be quite volatile. A long-term trend is nonetheless clearly apparent: gold reserves as a % of the monetary base have steadily fallen to an all-time low of 7.5% vs. a median of nearly 50%.

The proportions get even more absurd when one considers the total credit that is extended to both the public and private sector on the back of this monetary base. In the US, total credit is a staggering US63.4 trillion in 2016. That's 17x times the monetary base, and over 200x the US gold reserves backing that monetary base! And that's just within the US. On top of that, the Bank of International Settlements estimates that there is approx. $9.7 trillion in dollar-denominated debt outside of the US at the end of 2015.

Bottom line: if everybody suddenly decided to collect the debts they owned at the same time, there would not nearly be enough dollars to go around, let alone enough gold.

Now, remember that this debt is supposedly backed by the full faith and credit of sovereign governments. And yet every serious economist out there is telling us that most governments in both Western and emerging nations are on a clear path to insolvency and bankruptcy, unless they enact major structural economic reforms. So, it's anyone's guess how long will this confidence last...

Historically, during times of credit crises and financial distress, gold has been considered as the ultimate 'safe haven,' and its price has spiked. We believe it will continue to behave in such a way, making it an adequate hedge against a loss of confidence in the world monetary system.

And for those asking themselves 'what's the likelihood of that happening?' remember that what we're talking about here is far from unprecedented. Since the end of the Classical Gold Standard in 1914, we've altered our global monetary arrangements a number of times, typically every couple of decades.

We view a position in gold as an insurance policy against such an event, rather than as an absolute return investment or trading opportunity. Remains the question of whether this represents a cost-effective insurance policy as of today. We believe that the current opportunity cost of owning gold is relatively low, as both the yields on paper assets such as sovereign debt and the credit worthiness of that debt, as measured by debt to GDP, are at very low levels (as shown in Figure 6 below).

3.A potentially undervalued asset?

This claim is by far the hardest to establish. How does one value the intrinsic worth of a commodity that isn't a really productive asset, and therefore doesn't offer either a yield or the prospect of capital appreciation?

The most appropriate way that we can think of is based on the basic principle of supply and demand: or the existing stock of gold above (and to a lesser extent below) ground, and the demand for that stock.

The supply side is the easiest to deal with: we know with some level of reliability that the total amount of gold ever mined amounts to about 186'700 tons in 2016, according to the World Gold Council. And the US Geological Survey estimates that proven global reserves below ground amount to some 52'000 tons. To put this into perspective, this represents about 0.8 ounce per person of gold above ground (about 1.0 ounce per person of gold above and below ground). In short, on a per capita basis, there is not a lot of gold to go around! Furthermore, due to declining ore grades, gold production is expected to have peaked in recent years, at slightly over 3'000 tons per year. Scarp gold is another important source of supply, representing about 1/4th of total supply, or over 1'000 tons per year.

What about the demand side? According to a primer on gold by Bank of America - Merrill Lynch dated June 2015, jewelry demand accounts for over 2'000 tons per year, or about half of total demand, with India and China as the largest buyers. Other fabrication uses (electronic, industrial, and dental applications) add another 500 tons. Investment demand, both from the private sector and central banks, makes up the rest, or some 1'500 tons per year. It is worth noting that an increasing amount of gold's investment demand is now supplied by collective investment vehicles, such as gold exchange-traded funds (ETFs). As briefly discussed later, this is a very different proposition from actually owning the tangible commodity, which suffers from many drawbacks.

How does all of this fit into our evaluation of gold's intrinsic worth? As a first indication, we can consider that a commodity for which supply and demand are balanced should trade around its marginal cost of production, which is about $700 per ounce for gold (the 'all-in sustaining cost' is likely to be higher than that figure). We believe this represents a strong long-term floor for gold prices. We also believe that given the monetary imbalances described earlier, it would only take a small crisis of confidence for the investment demand in gold to skyrocket.

Again, let's try to put this into an appropriate context. At today's price, the total amount of gold ever mined represents a monetary value of about $6.6 trillion. By contrast, global institutional pension fund assets in major markets amounted to over $36 trillion in 2016, according to the latest figures by Willis Towers Watson. There's another $7.4 trillion in sovereign wealth funds' assets globally. If both of these heavy-weight categories of investors decided to attribute even just 1% of their total asset allocation to gold, that would represent a demand of over 12'000 tons at today's price. That's about 4x the global annual output, and 1/15th of the total amount of gold that we've ever mined!

Let's consider a somewhat more realistic hypothetical scenario: if the US were to back its monetary base, as used to be the case during the Gold Standard, say to the tune of about 40%, it would require a gold price of over $6'000 per ounce given its current physical gold reserves.

It seems quite obvious to us that any move, even small, in perception regarding the role of gold in the global monetary system would result in a manifold increase in the price of gold, in the 5-10x range.

On the other hand, downside risk in the long term is likely limited to the gold price falling towards its cost of production, or some 40%. Having said all of that, we state again that generating an absolute return is not the primary objective of having an allocation to gold.

4.Gold as part of an overall asset allocation

We've aimed to briefly outline our rationale for considering gold as part of an overall asset allocation given today's investment landscape. It is based on gold being i.) a suitable store of value over the long term, ii.) an effective hedge against a confidence crisis in our fragile global monetary system, and iii.) the large upside potential in the price of gold should that happen.

How much of total assets should we allocate to gold? Our recommendation is for an allocation of approx. 4%, with a discretionary potential to deviate +/- 2% depending on the investment and monetary landscape, as well as the price of gold.

This target allocation can be supported by a number of arguments. First, we've demonstrated the manner in which gold is an effective way to store wealth while protecting it from inflation.

Our gold allocation should, therefore, cover a portion of our long-term cash reserves. Second, we've argued that gold is an effective hedge against a fragile global monetary system. We believe that for any unlevered hedge to be effective, it should represent at least close to 5% of a total asset allocation. Anything less will simply not have the desired impact to overall investment results.

We recommend that the vast majority of the gold allocation should consist of physical gold, either in kilos or ounces, stored at a safe counterparty, and deliverable on demand.

We are very skeptical of 'paper gold' investments such as ETFs, for a number of reasons. First, because there is a huge difference between owning gold as a financial instrument vs. gold as a tangible commodity. As the main reason to own gold is to protect oneself against a potentially unstable monetary system, to take out such an insurance policy in the form of a financial instrument defeats the purpose. Second, one must consider the counterparty risk. For example, take the SPDR Gold Trust (NYSEARCA:GLD), which is the world's largest gold ETF. Its underlying custodian is HSBC, a bank that we consider to be far from a safe custodian in case of pronounced financial turmoil. Last comes the issue of the gold being deliverable on demand.

Again, sticking with our example of the SPDR Gold Trust, the prospectus states that you must own at least 100'000 shares to be eligible for physical gold delivery, which represents an investment of about $11.5m at today's price. What a joke! Basically, this sentence strongly suggests that their ETF is not 100% backed by physical gold. If there ever comes a point when people feel that it is no longer sufficient to own 'paper gold' in the form of an ETF, but that they rather want to own the actual physical commodity, then we may all wake up to the harsh reality that there are many, many financial claims on gold out there that aren't effectively backed by the physical commodity.

The only other form of gold investments that we recommend is gold mining companies located in developed economies and 'relatively safe' developing countries, such as Canada, Australia, the US, and South America. While gold above ground is the safest way to own physical gold, and investing in gold miners entails some additional risk related to mining activities, it also offers a number of advantages. First, it occasionally offers the opportunity to buy gold 'at a discount.' Because the spot price of gold generally exceeds the cost of extracting it, the valuation of gold mining companies with proven reserves can sometimes be at a discount to the price of gold, even after accounting for the cost of extraction. Second, established gold miners often pay out a dividend, which effectively represents ownership of proven gold reserves with a yield.

Third, gold miners offer a way to build some leverage to a physical gold position in a simple, clean, and cost-effective way. Historically, gold stocks are leveraged 2-3x to the price of gold bullion.

We recommend that the proportion of physical gold to gold mining companies in our overall asset allocation be approximately 80% to 20%.

5.Closing quotes

In closing, we want to reassure readers that we aren't completely crazy to advocate for a position in a shiny yellow metal that has no uses, doesn't yield anything, or offer the prospect of capital appreciation. To do so, we've included a number of famous quotes on the topic of inflation and the monetary system below:

'By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.'

- John Maynard Keynes

'Inflation is the one form of taxation that can be imposed without legislation.'

- Milton Friedman

'In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.'

- Alan Greenspan

'In reality there is no such thing as an inflation of prices, relatively to gold. There is such a thing as a depreciated paper currency.'

- Lysander Spooner

'The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.'

- Ernest Hemingway

'It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.'

'Give me control of a nation's money supply, and I care not who makes its laws.'

- Amschel Rothschild

'He who controls the money supply of a nation controls the nation.'

- James A. Garfield

'A system of capitalism presumes sound money, not fiat money manipulated by a central bank. Capitalism cherishes voluntary contracts and interest rates that are determined by savings, not credit creation by a central bank.'

- Ron Paul

[1] This is in the theoretical sense of the term, in that currency was fully redeemable in gold on demand, although still subject to the practice of fractional reserve banking, which meant that the actual coverage was always substantially below 100%.

The struggle between the Bannon and Kushner factions is about more than dynasty

PROXIMITY to power does not make Washington, DC, a kindly place. Like medieval peasants watching knights joust, the yokels and churls of the political village—lobbyists, consultants or (hold your nose) journalists—may nod and gawp at the mighty, but their hope is to see one grandee thwack another into the mud.These are, therefore, heady times in the nation’s capital. Two powerful men, Stephen Bannon, chief strategist to President Donald Trump, and Jared Kushner, a senior adviser, have been jousting for weeks, exchanging sword-swipes and lance-blows via leaks and briefings in the press. Still more blissfully for spectators, Mr Kushner is the president’s son-in-law: the boyish, dashing heir to a family of property tycoons and Democratic donors, and husband to Mr Trump’s daughter and trusted counsellor, Ivanka. His rival, Mr Bannon, is older and angrier: a grizzled champion of America First nationalism.This White House tourney is usually presented as a clash of partisan ideology or as a human melodrama. Some complaints from the Kushner camp certainly ring with dynastic alarm. The ultimate argument against Mr Bannon, one unnamed source told the Washington Post, is that his hardline, fire-up-the-faithful brand of politics “isn’t making ‘Dad’ look good”. For their part, Bannonites inside government and their cheerleaders in the conservative media like to paint Mr Kushner as a closet liberal, undercutting Mr Trump’s historic populist victory. Their ire also takes in Ivanka, as well as Gary Cohn, the president’s national economics adviser, and Dina Powell, a deputy national security adviser, both of them veterans of Goldman Sachs, a bank (to complicate matters, Mr Bannon also once worked for Goldman Sachs, but more recently earned notoriety as the rumpled, combative boss of Breitbart, a hard-right news outlet).When briefing against the Kushner faction, the Bannon camp uses such slurs as “the Democrats”, “the New Yorkers” or “the globalists”. Mr Kushner and his elegantly tailored friends are charged with being squeamish about immigration, too eager to see America play global policeman in Syria and peacemaker in the Middle East, and willing to give a hearing to Democratic experts on such subjects as health policy or climate change. Bannonites, Democrats and pundits have mocked Mr Kushner for the range of his responsibilities. The president’s son-in-law is charged with overseeing everything from Middle East peace to relations with Canada, Mexico and China, and reorganising the federal government using lessons from business.But to cast these fights as a clash between left and right, or even as palace intrigues, is to miss the whole story. The semi-public combat between Mr Bannon and Mr Kushner rests on an argument about something much larger: namely, the purpose of Mr Trump’s presidency itself.For Mr Bannon, the point of winning the 2016 election was to advance a cause, which history may in time call Trumpism. A former naval officer from a blue-collar family in Virginia, he spent years studying theories of how societies collapse. He has made several lurid, doomy films alleging that working families have been sold out by rootless, corrupt elites, who stood by and profited as immigrants flooded in. Other works lamented the collapse of Judaeo-Christian values in the American heartland. Mr Bannon saw before many others on the hard right that Mr Trump might not be a conventional conservative, but still “intuitively” grasped the power of economic populism. On joining the government as the president’s ideologue-in-chief, Mr Bannon pasted specific promises made in Trump campaign speeches on the walls of his West Wing office. Those promises cover everything from border security to global trade and an assault on regulations and the federal agencies that write them, through what Mr Bannon calls the “deconstruction of the administrative state”. Addressing conservatives in February, the strategist assured them that, whenever establishment types try to lure Mr Trump away from that radical agenda, “He’s like: ‘No, I promised the American people this, and this is the plan we’re going to execute on’.”

During the election Mr Bannon bonded with Mr Kushner in their shared contempt for professional campaign consultants. To hear Mr Kushner describe it, the Trump campaign resembled a disruptive startup, full of tech whizzes with “nontraditional” backgrounds outside politics. Addressing New York business bosses in December, Mr Kushner explained how the campaign exposed him to the anger of Americans who feel ignored by their government. He realised that he lived in a “bubble” of elite opinions about such subjects as immigration or the environment.

“I like Steve, but...”

However, Mr Kushner differs in at least one important way from Mr Bannon. He acts as if the last election was a victory for a man called Trump, not a movement called Trumpism. Shortly after the election Mr Kushner told Forbes magazine that his father-in-law transcends party labels, with policies offering “a blend of what works, and eliminating what doesn’t work.”Both men entered the White House rooting for Mr Trump to prove critics wrong. But if Mr Trump prospers by breaking every campaign promise, Mr Bannon’s nationalist cause will have been betrayed. The strategist has survived until now by telling Mr Trump he can help him keep those pledges, shoring up his most loyal bases of support. Yet over time, history suggests that seeking to bind Mr Trump with his own words is a losing gambit.The logic of Mr Kushner’s family first pragmatism is simpler: Americans will thank Mr Trump if his policies improve their lives. For now both men offer the president possible paths to success. At some point their visions will prove incompatible—hence recent rumours, fuelled by Mr Trump, that Mr Bannon may be sacked. The prize being fought over is the president’s legacy. That is a contest not everyone can survive.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.